A Closer Look at Fed Liquidity
Liquidity sets the stage for higher asset prices in the future; it does not necessarily have to do so immediately
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Ojai sounded great! I would so much rather have been there than in the faculty discussions, course preparations and article / book chapter writing.... as for next year, how about somewhere near Saratoga racetrack?!! And a little earlier in the month to catch some big races (and when I am more free??)!!
Here is my question - I've been pondering this and don't know which professor is the best to ask. Feel free to forward this to the most appropriate person(s).
If indeed the Fed is pumping more liquidity as the market reaches critical points of near breakdown as Buzz correspondence recently suggested, what keeps those with access to the cheap dollars from spending it on trades that bet the market will go lower? Is it only the psychology leg of the table? Is it simply the number of "buy the dipsters" are large enough or well supplied enough to force a squeeze higher?
No one ever discusses this as they ponder market intervention / manipulation. The assumption seems to be that the Fed pumps and those with access to the pump buy (or attack the price of precious metals). It would be interesting to analyze the pattern of Fed redemptions with market near breakdown reversals vs. when it didn't help and the market fell and maybe was even inadvertently Fed (yikes, what a choice of words!) in the fall by the redemptions / pumping liquidity.
Maybe this is a terribly naive question, but I always encourage my students to ask such questions because they make the entire class think, myself included.
Proud to be a Minyan...
Liquidity sets the stage for higher asset prices in the future; it does not necessarily have to do so immediately. But market participants that track liquidity figures and see them rise today make assumptions about the asset prices in the future and may buy assets today as a result (perception).
For example, the Fed conducted $6.5 billion in repos today; this adds liquidity to the system until those repos expire (or maintain it if rolled). There is nothing in that immediate liquidity that is used to buy stocks, but those who monitor that figure may buy today assuming that liquidity will bid asset prices higher in the future. Why?
The Fed agrees with broker / dealers to buy a t-bond out of their inventory for a certain period (repo). Consequently, the dealer (say JPM) now has extra cash on hand. JPM itself doesn't buy stocks with it, they lend it out to customers, or more accurately, it lowers the broker/call or inter-bank interest rates, which encourages customers to borrow it. Customers can certainly short securities with it, and they do sometimes, but the real effect is that excess liquidity lowers interest rates, which tend to over periods of time increase asset prices. This is inflation (excess cash) and can go to hard assets or financial ones. (Also refer to a piece I wrote on the step by step process of the multiplier effect.)
The key to immediate influence on asset prices like stocks is that market participants see the repo activity today and assume that asset prices will increase in the future, so they do not wait, they buy stocks today with available cash.
Of course that doesn't mean they will be right in the long run. Deflation is an interesting phenomenon (and a very special case) where the excess cash is hoarded (instead of spent or lent) because investors begin to raise their risk assumptions and reduce their time preferences. This is what the Fed is desperately fighting.
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